Derivatives and attempted state capture in Kazakhstan

A fascinating contribution by Gillian Tett in today’s Financial Times on the role of CDS in the default of the largest Kazakh bank, BTA, raises a number of wider issues. Last week, BTA went into partial default when Morgan Stanley and another bank demanded repayment of loans they had made to BTA and BTA was unable to comply. Tett also discovered that, just after calling in its loan to BTA, Morgan Stanley asked the International Swaps and Derivatives Association (ISDA) to start formal proceedings to settle credit default swaps contracts written on BTA. I don’t know the aggregate value of the credit default swap contracts written on BTA that Morgan Stanley owned, whether it was smaller or larger than the value of the loans to BTA called by Morgan Stanley, or who the writer(s) of these CDS contracts was or were. But it raises concerns.

The reason it raises concerns can be made clear with the following hypothetical example. Assume some large western bank, let’s call it St. Manley Organ Bank, has made a loan of size A to BTA or has bought its debt in amount A. As a creditor to BTA, St. Manley Organ would normally want to avoid a default by BTA, because St. Manley Organ is bound not to get paid in full in the event of a default by BTA. But now assume that St. Manley Organ has also bought CDS in amount L to cover the risk of default on BTA debt. As long as A > L, St. Manley Organ has a net long position in BTA debt, and it will get hurt financially if BTA defaults, even if the writer of the CDS is creditworthy and pays up in full. The purchase of CDS therefore is the purchase of insurance: St. Manley Organ has an insurable interest.

However, CDS can be bought in any amount without the purchaser having any insurable interest in the underlying security. If St. Manley Organ had bought CDS contracts for a larger amount of BTA debt than it owns, that is, if A < L, then St. Manley Organ has a net short position in BTA debt, provided the writer (seller or issuer) of the CDS is creditworthy. It is better off if BTA defaults than if it does not default. It profits from a BTA default.

If you own CDS written on BTA in an amount larger than the amount of BTA debt you own, you are not insuring yourself against the risk of a default by BTA and the resulting loss this would cause you. Instead you don’t have an insurable interest and you are placing a bet on a default by BTA. You win your bet if and only if BTA defaults. This would not matter greatly if St. Manley Organ had no way to influence the likelihood of default of BTA. But if St. Manley Organ can influence the likelihood of default of BTA there would be a nasty case of moral hazard.

Gillian reports that “Right now more than $700m BTA CDS contracts are registered with the Depositary Trust & Clearing Corp in New York”. The two loans BTA defaulted on were worth $550 million . This does not mean that someone made a $200 million profit: total outstanding borrowings of BTA were around $13 billion, and it is quite possible that some or all of the CDS in question were written on the $12.250 billion worth of BTA debt that has not defaulted (yet). But it does cause one to ponder.

Moral hazard causes what I call micro-endogenous risk. It is a powerful argument for requiring purchasers of derivatives like CDS to have an insurable interest. In this case it would have meant that you cannot own CDS in excess of the amount of BTA debt you own. This can be enforced by requiring that a CDS contract only pays off if the same amount of the exact security the CDS was written on, is presented and handed over to the writer of the CDS.

I favour requiring CDS contracts to become instruments of insurance rather than instruments for placing bets – for gambling. This is both because of moral hazard considerations and because the tradability of the CDS contracts adds a dimension of macro-endogenous price risk to the micro-endogenous price risk caused by moral hazard. This would mean banning ‘naked CDS’, the analogue in the CDS market of banning naked short sales of equity.

Kazakh tax payers versus foreign unsecured creditors

There is a second issue. Last February, BTA, which had been a privately owned bank, was nationalised by the Kazakh state. When it became clear that BTA, like most of Kazakhstan’s banks was tottering on the edge of the precipice, the foreign unsecured creditors of the bank began to lobby the Kazakh government to guarantee the bank’s unsecured liabilities. Pledging the resources of Kazakhstan’s National Oil Fund to rescue the unsecured foreign creditors is an option that is especially popular with those who were caught with their pantaloons down. There is no insurance like ex-post insurance.

When first BTA and then a second Kazakh bank, Alliance Bank, went into partial default, the sound of foreign bankers lobbying the Kazakh government became a might roar. Those doing the lobbying were presumably those long in Kazakh bank debt, that is, creditors whose credit exposure exceed their holdings of CDS contracts written on Kazakh bank debt and the writers of the CDS.

About 40 percent of the liabilities of Kazakh banks are held by foreigners, mainly by banks and investment banks. State ownership of a bank does not, of course, mean that the state guarantees any of the liabilities of that bank. Limited liability means that the exposure of the state, like that of any owner, is limited to the state’s equity in the bank.

The foreign creditors of BTA were not simple widows and orphans who put their money in IceSave accounts without being able to spell the word ‘insolvency’. They are sophisticated, professional financiers, who earned very handsome spreads over US Treasury bonds by lending to Kazakh banks. This lending became grossly undisciplined and led to a massive investment, construction and real estate boom as the world economy thundered along and the prices of oil and gas (Kazakhstan’s main exports) skyrocketed.

A mole wearing sunglasses could have seen the Kazakh boom was unsustainable and would crash. There never were creditors more undeserving than the creditors of Kazakh banks. The spread between US Treasury bonds and US$-denominated Kazakh bank debt is called a (differential) credit risk spread. When you see it, it means that there is likely to be greater credit risk associated with the security earning the higher yield. The spread is the reward for bearing that risk. Sometimes that risk comes home to roost. Then you have to eat it. That’s known as the rules of a capitalist market economy.

The World Bank and the IMF, in countries as far apart as Iceland and Kazakhstan, have been on the side of the angels, arguing strongly with the governments of these countries that the state should not guarantee the foreign liabilities (or indeed any liabilities other than insured deposits) of banks that are in default or threaten to go into default. Icelandic tax payers should not pay for the follies of foreign banks (including some well-known German banks) that lent serious money to the Icelandic banks long after it was obvious that the Icelandic banking system was an accident waiting to happen. The foreign banks lobbied and continue to lobby furiously, and even recruit their own governments to put additional pressure on the Icelandic authorities.

In Kazakhstan, some of the foreign banks that lent unsecured to the Kazakh banks are not only lobbying furiously – they are playing hardball, threatening to invoke assorted cross-default clauses in loan contracts that could bring down most of the Kazakh banking system. There is no financial upside for the creditors from following through on that threat, but there is, of course, considerable downside for the Kazakh government and people. Such behaviour is deeply unethical and should be illegal. I hope the home governments of the foreign banks that are financially exposed in Kazakhstan have the good sense either not to get involved at all, or to take the side of the Kazakh tax payers.

The sight of bankers from the rich industrial countries capturing their home governments is bad enough. To watch them attempting to capture or bully foreign governments, often in emerging markets or developing countries, is truly objectionable. It is time to play the international lending game with an honest deck.

Maverecon: Willem Buiter

Willem Buiter's blog ran until December 2009. This blog is no longer active but it remains open as an archive.

Professor of European Political Economy, London School of Economics and Political Science; former chief economist of the EBRD, former external member of the MPC; adviser to international organisations, governments, central banks and private financial institutions.